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You may have heard warnings about being careful not to overfund your cash value life insurance for fear of triggering a modified endowment contract (MEC). But what exactly is a MEC? In short, a MEC is a life insurance policy in which funding has exceeded federal tax law limits. If your insurance policy becomes a MEC, you lose the favorable tax treatment you'd otherwise enjoy with a cash value insurance policy. Here's what you should know.
A Little Background
MECs originated in the late 1980s, after interest rates on cash value life insurance policies had hit a jaw-dropping 20 percent. In addition to their impressive interest rates, these policies also avoided the kinds of taxes more traditional investments faced, because of the way the IRS taxed permanent cash value life insurance policies.
In such life insurance policies, your cash value grows tax-deferred, and any withdrawals you make are taken out on a first-in, first-out (FIFO) basis. That means you can access your money tax-free up to the cash value of the contributions you've paid in through your premiums. You can also take a tax-free loan from the cash value (although such a loan may create an income-tax liability, be subject to interest, reduce the cash value and death benefit, and cause the policy to lapse).
Prior to the advent of MECs, it was possible to invest a large sum of money in a small permanent life insurance policy, effectively creating a potentially high-growth, tax-sheltered fund. As a result, Congress passed the Technical and Miscellaneous Revenue Act (TAMRA) of 1988, which instituted MECs.
What Is the 7-Pay Test?
TAMRA was put in place to discourage investors from using life insurance for investment-tax avoidance. The legislation put limits in place regarding how much money you can pay into a life insurance policy over a set period of time. Exceed the limits set by the IRS and the policy then becomes a MEC.
These limits are called the "7-pay test." A policy will fail the 7-pay test and trigger a MEC if the policyholder pays premiums in excess of the amount needed for the policy to be paid up in seven years.
The 7-pay test is generally used only in the first seven years after purchasing a policy, unless there's a material change to the policy, such as a reduction in the death benefit, in which case a new 7-pay test must be run.
You Shouldn't Be Surprised by a MEC
Insurance companies typically perform MEC tests on a monthly basis. That allows them to alert policyholders to any overfunding that may occur before the MEC is triggered. In addition, the government offers 60 days to your insurer to return any overages before a MEC trigger. So even if there's an accidental overage, your insurer has two months to return the overfunded amount to you. After a life insurance policy becomes a MEC, it cannot be reclassified as a standard life insurance policy again.
For any policyholders who specifically want a MEC, single-premium life insurance is considered one from the outset, because it's funded with a single, large premium.
What Are the Tax Implications?
So why does it matter if your policy is a MEC? In a word, taxes. With a MEC, you lose the favorable tax treatment you'd otherwise enjoy when you make a cash value withdrawal or take a loan from your policy.
For one thing, your money will no longer be withdrawn on a FIFO basis, but instead as a last-in, first-out (LIFO) withdrawal. This means your distributions will come from the interest on your cash value first — and will therefore be taxed as regular income.
In addition, just like withdrawals from tax-advantaged retirement accounts, you'll pay a 10-percent penalty on any withdrawal you make prior to reaching age 59 1/2. For anyone who has a permanent life insurance policy in order to maintain access to their cash value, these considerations can present a serious problem.
The Importance of Educating Yourself
There are significant tax implications to consider with a MEC, so it's important to be educated. If you're concerned about whether your policy may become a MEC, or you need more information, consider seeking the advice of a financial representative.